A relevant cost for decision-making is a cost that varies when evaluating two or more alternatives. Relevant costing is used only for short-term and nonroutine decisions. While relevant costs are important, managers should also consider nonquantitative factors in decision-making. In this article, we’ll go over the process of relevant costing and how you can apply it in a sample of common business decisions.
Key takeaways
- Relevant costs are costs that vary between two or more alternatives being considered.
- Irrelevant costs are unavoidable and don’t vary across alternatives.
- Generally speaking, most variable costs are relevant while most fixed costs are irrelevant. However, exceptions may arise in different scenarios or circumstances.
- An important element of relevant costs are opportunity costs, which represent the value of an alternative given up in favor of another.
- Common decisions made using an analysis of relevant costs are outsourcing decisions, special order decisions, continue-or-shutdown decisions, and change-in-profit decisions.
Identifying Relevant Costs
In managerial accounting, relevant costs to a particular decision are those that vary between the alternatives being considered. For instance, a relevant cost to a particular decision could decrease in revenue with alternative A compared to alternative B.
Costs that aren’t associated with the decision are irrelevant and ignored in the decision-making process. Let’s say you’re deciding if you should use a particular building to produce product A or B. In the scenario, the purchase price and maintenance cost of that building are irrelevant.
In general, most variable costs are relevant while most fixed costs are irrelevant. This general rule holds true most of the time since variable costs behave differently across activity levels while fixed costs remain constant nonetheless. However, fixed costs that can be removed under one alternative are relevant.
Example
We are deciding whether we should make or buy component ZH300, a special component needed in one of our products. If we decide to buy the component, we’ll be able to shut down our current factory and earn additional income by renting it out. We’ve gathered the following information:
Cost Information | Relevant? |
|---|---|
Cost of raw materials needed to make component ZH300 | Yes |
Cost of labor in raw materials inspection and parts assembly | Yes |
Salary of factory supervisor | Yes |
Overhead costs related to the production of component ZH300 | Yes |
Rent income for leasing out the production facility if component ZH300 is outsourced | Yes |
Purchase price of ZH300 from third-party supplier | Yes |
Original purchase price of the production facility | No |
Cost of three full-time custodians that clean the production facility plus 10 other buildings | No |
Cost of raw materials needed to make component XB300 at a different facility | No |
Salary of cost accountant who is in charge of computing costs in all production facilities | No |
Salary of CEO allocated to production facility | No |
- The yellow cells are relevant costs to make component ZH300. If we decide to make the component, we will incur these costs. Moreover, pay attention to the rent income for leasing out the production facility. This is a relevant cost because we’re giving up the rent income if we decide to produce the component.
- The blue cell is a relevant cost for buying the component. By choosing to outsource, we will only pay the price of the third-party supplier.
- The gray cells are irrelevant to our decision. For instance, the original price of the production facility is irrelevant because it is a sunk cost. This cost had already been incurred in the past and there’s no amount of effort in the present that can alter this sunk cost. Therefore, we don’t consider this in our decision.
Relevant Costing Decisions & Examples
The goal of relevant costing for decision-making is to select the decision that would result in the highest incremental benefit to the company.
Below, we provide the common relevant costing decisions and examples that you might encounter in your small business. We also show the computations on how the decision will affect your margins and financial performance.
We illustrated each relevant costing decision into two parts, quantitative and qualitative:
- Quantitative factors show the financial impact of the decision.
- Qualitative factors are often nonfinancial in nature but still have a significant impact on your decision.
Take note that these decisions are nonroutine decisions, which means that you don’t make these decisions regularly. They arise only because of changes that may occur because of sudden and short-term changes in business operations.
An outsourcing decision arises when the company considers buying a component from a third-party supplier, even if it can make it internally. Managers are often faced with an outsourcing decision if there are talks about cutting costs.
Producing internally can be costly, given the overhead costs associated with production. Meanwhile, buying from a third-party supplier may appear more attractive because it relieves the company from overhead costs.
We’re planning to outsource the production of 20,000 electric components. A third-party supplier is offering to produce the component at $10 per unit. The cost of producing each component is as follows:
- Direct material cost per unit: $1.80
- Direct labor cost per unit: $3.50
- Overhead cost per unit: $2.20
If we decide to produce internally, we will use the production facility that we can lease out to interested parties at $10,000 per month. Should we make or buy the component?
Cost of making = $1.80 + $3.50 + $2.20 + 50 cents
$10,000 ÷ 20,000 units (opportunity cost for using the facility instead of leasing it out)
= $8 per unit
Cost of outsourcing = $10 per unit
Most likely decision: Based on the quantitative information, making the component internally is $2 cheaper than outsourcing it, saving us $40,000 in total.
A special order decision arises when customers request to buy a special product that’s not part of the normal product line. For example, the famous chocolate candy brand M&M’s offers “party favors” to customers who want personalized M&M candies with their names printed on them. This type of order can be a special order since it’s not part of M&M’s regular product line.
More likely than not, special orders aren’t considered in the budgeted production. It is possible for some companies to receive special orders when they’re already at full production capacity. It’s either the company will accept the order and forgo a portion of production or reject it.
Example 1
Let’s assume that a company wants to order 200 specialized polo shirts from our clothing brand with a bid price of $26 per shirt. The company agreed that we keep our branding as long as we print the company’s logo. We are currently operating at full capacity and if we accept the order, we might forgo 200 units of normal sales just to accommodate the order. Below are cost information for producing one polo shirt:
- Selling price to normal customers: $29 (opportunity cost in accepting the order)
- Direct material per shirt: $5.25
- Direct labor per shirt: $8.75
- Overhead cost per shirt: $6.50
- Cost of printing logo per shirt: $0.20
Since we are at full capacity, we will be unable to sell 200 units to normal customers. Hence, we will lose a $7.5 ($29 – $5.25 – $8.75 – $7.50) CM per unit.
Cost of special order = $5.25 + $8.75 + $6.50 + 20 cents + $7.5 = $28.20
Most likely decision: Reject the special order because producing one unit costs $28.20 while the customer’s bid is only $26. Accepting the order would result in a loss of $2.20 per unit, or $440 for the entire special order.
Example 2
Assuming we still have excess capacity to accept 200 units of special order, should we still reject the order?
Cost of special order = $5.25 + $8.75 + $6.50 + 20 cents = $20.70
In this scenario, there is no opportunity cost to accept the special order since we can produce the order without lowering other production. Therefore, the cost to accept the order doesn’t include the lost CM per unit.
Most likely decision: Accept the order because producing one unit costs only $20.70, while the customer’s bid is $26. We profit $5.30 per shirt, or $1,060 for the entire special order.
Deciding whether to continue or shut down a segment or product line is a tough decision. Perhaps, during the height of the COVID-19 pandemic, many businesses had to shut down all or a portion of their operations. Some small businesses probably had to close completely rather than sustain continued losses because of poor sales and rising costs.
The decision to discontinue operations involves looking at factors that are relevant only to the segment, not those that are outside its control. Examples of irrelevant factors are common costs and allocated costs. In general, costs that are avoidable are considered in the analysis. Instead of looking at the overall margin, try looking at the segment margin and see if it is still profitable without considering common costs.
Because not all costs are relevant, it’s very possible that an unprofitable line should not be shut down. Shutting it down would result in an even greater loss.
Let’s assume that we are considering discontinuing the Wyoming branch of our business due to consistent negative profits in the past quarters. Below is the information we gathered:
Wyoming | |
|---|---|
Sales | $270,000 |
Less: Variable Costs | $162,000 |
Contribution Margin | $108,000 |
Less: Fixed Costs | $150,000 |
Net Income (Loss) | $(42,000) |
In our analysis of the Wyoming branch’s fixed cost, we uncovered the following:
- Advertising costs of $10,000 and supervision salaries of $30,000 will be discontinued if we drop the segment. These fixed costs are avoidable and therefore relevant.
- The remaining fixed cost of $110,000 will continue even if the branch is shut down and is therefore irrelevant. Irrelevant fixed costs include cost allocations from the central office.
Wyoming | |
|---|---|
Sales | $270,000 |
Less: Variable Costs | $162,000 |
Contribution Margin | $108,000 |
Less: Avoidable Fixed Cost | $40,000 |
Segment Margin | $68,000 |
Less: Unavoidable Fixed Costs | $110,000 |
Net Income (Loss) | $(42,000) |
Notice that Wyoming’s segment margin is $68,000. The reason why Wyoming is at a net loss is due to irrelevant fixed costs, such as common costs allocated to the branch. If we remove those costs, we can say that Wyoming is profitable with a segment margin of 25% of sales.
Most likely decision: Don’t shut down the Wyoming branch because doing so will increase the loss from $42,000 to $110,000—which are the unavoidable fixed costs that remain after the shutdown.
If the Wyoming branch is shut down, the company would most likely reallocate fixed costs and the remaining branches would be burdened with an additional $110,000 of fixed costs. The Wyoming branch wouldn’t be shown in the financials with a $110,000 loss. Instead, all the other branches would be less profitable by $110,000.
Undertaking certain business decisions has an impact on overall profit. For instance, purchasing advertising services from a marketing firm will increase advertising expenses but should bring in more sales to the company. When making this decision, you need to make sure that you’re maximizing every dollar invested and getting a high return.
For illustration purposes, let’s assume that we want to boost our sales by doing the following:
- Hire a new vice president for sales to improve the company’s sales; the annual salary agreed upon is $200,000
- Subscribe to a new CRM software that costs $12,000 per year.
- Organize a retraining program that costs $135,000 for existing sales employees
Based on forecasts, these changes should grow sales by 30%. Current sales level is $1.5 million.
Incremental Sales ($1.5 million x 30%) | $450,000 |
Less: Salary of Vice President for Sales | $200,000 |
Less: Cost of New CRM Software | $12,000 |
Less: Cost of Retraining for Employees | $135,000 |
Incremental profit | $103,000 |
Most likely decision: Pursue the plan because it will yield an incremental profit of $103,000.
Frequently Asked Questions (FAQs)
A relevant cost is a cost that differs across alternatives. It is associated with the decision, is important to the decision-maker, and has a bearing on the future.
Costs that are incremental to the decision are considered relevant. These incremental costs affect only a short period, usually less than a year.
Bottom Line
Relevant costs for decision-making help us determine the financial implications of business decisions. It also helps assess if it’s worth pursuing a particular alternative course of action that will lead to an incremental benefit to the company as a whole.
